According to Wikipedia, http://en.wikipedia.org/wiki/Subjective_theory_of_value, “The subjective theory of value is a denial of intrinsic value. It leads to the conclusion that there is no proper price of a good or service other than the rate at which it trades in a free market”
So, sounds like this theory is closer to Efficient market theory.
But, isn’t it true that investors like Warren Buffet makes money exploiting the difference in exchange value (price) and intrinsic value ? Doesn’t subjective theory of value suggest market inefficiencies ? How does subjective theory of value explain booms (bubbles) ?
Booms and busts occur because of the business cycle brought on by inflation. Inflation produces changes in valuation because it interferes with signals that businessmen use to form their impression of what future consumer tastes will be. Buffett makes money by purchasing a controlling share, or large enough share to make a difference, and changing the way the company operates. You could also make money by trading on time differences - i.e. the valuation people attach to something can change over time. You can buy stocks betting that in the future, people will value the company differently than they do now. The subjective theory of value applied to stocks doesn’t imply efficient market theory because Austrians recognize the importance of time and uncertainty.
Booms and busts occur because of the business cycle brought on by inflation
Are you suggesting that booms and busts don’t / won’t happen under gold standard ? I don’t think that’s true, as speculative bubbles can occur even when there is no inflation, though I don’t have examples with me now.
Buffett makes money by purchasing a controlling share, and changing the way the company operates
This is generally true, but not always true. Take Petrochina for example, Buffett bought a stake, but not a controlling stake in 2000 or 2001 and sold all of them recently. He saw that the intrinsic value of PTR was high a few years back when compared to the market value and exploited that to his advantage. In several speeches, Buffett has said so.
I wouldn’t ask you to point to one - I’m not an empiricist. However, I will ask you to reason one out - explain how it happens.
Yes, people say things all the time. Buffett is not an economist, and certainly not an Austrian economist. He might very well believe in intrinsic value - many people do. That doesn’t mean it exists. What he could have said that would have been correct is that he saw that in the future, people’s opinions would change, and as a result, the subjective value people assigned to Petrochina would rise.
It happens because of “extraordinary popular delusions and the madness of crowds”. The book cites several examples of that. People tend to follow the crowd, it is psychological, they want to conform to the society. So, they follow the latest fad and buy things at any price - tulip mania for example. I don’t think (I could be wrong) they had paper currency in those days.
Another recent example is housing bubble. The intrinsic value of the house doesn’t increase - it provides you shelter. However, people bid up the price of houses to astronomical levels. By subjective theory of value, I assume , there is no housing bubble.
Based on subjective theory, anyone purchasing a stock is clearly gambling - gambling that at some time in the future, people’s opinion of that stock will change. All stock valuation models are meaningless, since there is no IV for a stock. Are these statements right ?
In Austrian economic theory there is no exchange value nor is there any intrinsic value. The value of a good is purely subjective; i.e. the value of a good is simply what each person assesses the value is to them. If you own something (let’s say a book) that I value more highly than something that I own (let’s say a CD), and you value my CD more highly than your book, then there exists a double coincidence of wants and we will exchange the goods. This is not to say that they are of equal value because clearly we both place different values on each item. Therefore there is no intrinsic value. Ex ante, (i.e. before the transaction takes place) I believe I will profit from the transaction and so do you, so we both win. Ex post, we may still believe this to be the case, or we may not (I’m assuming no fraud takes place here).
If Warren Buffet values a company’s stock more highly than $10, and the owner of the stock values the $10 more highly than the stock, then the exchange will take place, but again this does not mean that the value of the stock is equal to $10. The market price for a stock is simply it’s price at the margin, but each player in the market will value the stock differently. Therefore the market price is not an exchange value. That is to say, in the market there will be some buyers who value the stock much more than $10, and some sellers who value it much less than $10. Warren Buffet makes his money, not by exploiting any difference in exchange value or intrinsic value. He makes his money, by being more right about the future value of that company’s stock in the market place. This is the defintion of a sucessful entrepreneur.
He makes money by exploiting the differences in the subjective values perceived by different parties.
Assuming there were such a thing as intrinsic value, how could one go about exploiting a difference between it and exchange value? One party would have to be seeking to trade at intrinsic value while another wants to trade at exchange value. But how did the one who wants to trade at intrinsic value discover what intrinsic value is? It could only be his subjective opinion so in reality both parties are trading based on their subjective values.
By what standard do we decide what is and what is not efficient? Is this not also purely subjective?
It doesn’t. The business cycle is explained by interference in the economy - usually interference with the value of the currency or manipulation of the interest rate.
It is definitely possible to have business cycles with a gold/silver standard. Particularly if fractional reserve banking is practiced. Here’s an article on 14th century Venetian banking: Fiduciary Media and Banking in Medieval Venice Revisited . Also, deSoto’s book covers the history of banking practices and their effects.
But how did the one who wants to trade at intrinsic value discover what intrinsic value is?
By intrinsic value, I mean the book value. Let’s say for example: a retailer. The retailer owns real estate where the stores are located. It has products in its stores and warehouses. You can check the value of the real estate today, sure it may go up or down tomorrow, but you can find the “market price” of that real estate based on the last transaction. Granted, we won’t know what the next transaction would be, but this is the best approximation. Also add up the sale value of all the products. + the cash in hand - liabilities. Now, let’s say you add all the up and get a value of $10/ share. This is what I see as the intrinsic value - if I dismantle the business today, this is what I will get approximately based on the last transactions in the market. Now, a fast growing business will be valued much higher than the book value. A slow business with probably trade at or below book value. A fast grower priced at or below book value is mispriced in my opinion. Investors look out for such opportunities.
Another good example is closed end mutual funds. There mutual funds hold several stocks. If you add the prices of all the stocks multiplied by their composition percentage, you get the intrinsic value of the fund. There are many closed end funds that trade above or below their intrinsic value. Most of them bridge this gap over time.
Everyone values things differently. I hate seafood, I wouldn’t pay anything for it. Someone else might prefer it over steak. Thus prices are subjective. There are no “proper” rates of exchange, you can’t say “1 cow is worth 12 chickens.” You can only say, “Joe will trade me 12 chickens for my 1 cow”.
There is no winner or loser in a trade. Trades happen when both people value what the other is offering higher than what they are offering. Why would anyone trade something for something worth exactly the same thing?
Speculation is when people see that a price is higher or lower than it will be in the future. You don’t need to understand how prices are formed to understand speculation.
If there is a cow shortage, a single cow will buy more chickens. That is how speculation works. It is only possible because prices are subjective and change continually.
How does intrinsic value explain busts? If a cow is worth 12 chickens, how did the price ever become 15 chickens?
“Booms” are brought about by credit expansion and money creation. New money must enter the economy at a certain point, usually most of it at the same point. This causes prices for say, land, to become artificially higher than the price for everything else. The prices than no longer accurately represent the aggregate subjective value placed on land relative to everything else.
If the credit expansion slow or stops, the price levels will even out as the effects of the monetary expansion spread to the entire economy. When this happens many land investments are no longer profitable so money rushes out of land speculation in search of profitable investments. That is a bust.
You can have credit expansion under a gold standard because of fractional reserve banking. If a bank has $100 of gold and $100 of bank notes, then prints another $10 of notes without increasing there gold stock they have increased the money supply.
There are always “market inefficiencies,” thats what causes the phenomenon of profit. People are trying to satisfy as many wants as possible with finite resources. If someone can use resources in a way that provides more satisfaction than alternative uses, they have created a profit margin. If something provides less satisfaction than the value consumed to make it, they experience a loss.
There is nothing inherently wrong in what you say here although I would use slightly different terminilogy. However, the key phrase you use is “mispriced in my opinion” . This is your subjective valuation of the business. If your subjective valuation of the business is greater than the current market price, then you should buy it. If in the future it turns out that the market price goes down instead of up, then you will lose money should you sell it. If making a money profit is your sole objective (i.e you’re not buying the business for any psychic revenue) then clearly your valuation of the business was misplaced viz a viz the market because it didn’t enure to your benefit, and it resulted in a net loss.
So I was splitting a hair over a semantic difference? Well OK, but if so then we should talk about book value and not about intrinsic value. That Wikipedia article is quite explicit in defining intrinsic value to mean objective value.
The answer, aside from what has already been given, is simple: intrinsic or objective value wouldn’t change over time. The very fact that how people value a thing changes over time absent changes in the nature of the thing itself necessitates that value is subjective. Electrons have intrinsic values, weight and charge. A retail store does not. It has subjective value now, which is likely different than the subjective value it had in the past and will have in the future, and might have if someone buys it at the current price and changes things about to increase its value, and all will likely be different than the liquidation value of all the resources making up the thing. People who assert the idea of intrinsic value are really saying they believe their subjective judgement is better than other people’s. They may be proven right in tme, the value is still subjective.
Let me give another example. A retail store that owns nothing. The store is leased and holds no inventory - they take orders and deliver. However, they have $10mm cash in hand, ($10/ share) which they have put in T-bills. The company generates just enough money to meet its expenses. Are you suggesting that this company has no intrinsic value though it has $10mm in cash ?
For some reason, the stock is selling at $1. At $1, someone can buy the entire company for $1mm, sell it off and pocket $9mm. Please explain to me why this company does not have an intrinsic value of $10/share.
I think this might be just a question of semantics. It depends what you mean by “intrinsic value”. If you mean it’s “book value”, then there’s nothing wrong in what you say. The market price is simply the price at the margin representing the subjective valuations of all buyers and sellers at any given time, and if there is a difference between book value and market price, it might be possible to exploit that difference and make a monetary profit.
The problem with a phrase like intrinsic value, though, is that it implies that the stock has a “true” price or a worth that can be determined independently of people’s subjective valuations. It implies that the market price is wrong and that the intrinsic value is correct. In Austrian economic theory, there is no correct price.
Suppose in your example, the $10m was held in cash in $5 bills, and suppose further there existed a nationwide aversion to Abraham Lincoln, such that very few people would accept these bills. The “book value” of the stock might be $10, but there could be a very good reason why it was selling at less than book value. Or there might not be. Who’s to say? The value of the stock as you see it is simply your subjective assessment at a particular point in time. If you buy it at $1 and then later sell it at $10 because the populace suddenly falls in love with Abraham Lincoln, good for you because you made a profit, but that doesn’t mean the stock’s price was incorrect when you bought it. Other players may have erred in not forecasting the future as accurately as you, but this is not to say that the correct price was $10 all along.
Ok, so, a stock does not have intrinsic value. The subjective valuation of the stock varies with time. Good.
Two questions:
How does good investors consistently make money ? They buy a stock when the subjective valuation is low and sell when the subjective valuation is high. But, not all stocks go up in valuation. Some stocks that are low in valuation will stay low or go bankrupt. You cannot just depend on luck on for valuations to go up. Luck doesn’t explain consistent performance by successful investors. They study and understand the business fundamentals. PetroChina having great business prospects in 2001, for example. It may be subjective, but great investors are consistently right on this, that I think it is more objective and subjective.
Someone mentioned inflation as the cause of bubbles. Blame it on anything, inflation, fractional reserve banking etc. But the fact, is people who bought stocks with their subjective valuation of dot-com companies in 2000 were wrong. The market thought Cisco was worth $100 in 2000. Their valuation of Cisco was way wrong. A lot of experienced investors knew it while it was happening. Everyone knows it now, on hind sight. So, what do you call the valuation assigned by experienced investors who avoided the dotcom crash ?
Great investors, speculators, entrepreneurs make their money by correctly predicting the future. That is, they anticipate more correctly than others the future needs of the market. In a hypothetical “evenly rotating economy” there is no role for entrepreneurs because there is no uncertainty. In the real world, uncertainty is everywhere, and good entrepreneurs predict what future needs will be as a result of this uncertainty. You are right, they are not just lucky. They use all their experience to be more correct about the future than others. But if predicting the future simply meant cruching a few numbers in a computer, if it were that simple, then everyone would do it, and there’d be no profit for the entrepreneur. Looked at a different way, if number crunching or some other methodology could always predict the future, there would be no uncertainty. Prediction, therefore is an art, which only a relatively few people do successfully.
Investors who sold their stock before it went bust were better entrepreneurs, they predicted the future better than others. They did this through intuition, life-experience, knowledge about the market etc. But you must be careful when you say “people who bought stocks with their subjective valuation of dot-com companies in 2000 were wrong”. Yes, if they bought stocks to make money (and not for some other reason), they were wrong about the future direction of the market. But their subjective valuation of the stock was not wrong. They truly believed that this is what the stock was worth to them ex ante, otherwise they wouldn’t have bought it. The fact that they may have later sold the stock at a loss simply proves they weren’t good entrepreneurs (predictors of the future),. The crucial point here is that even though it may seem obvious to you that I’ve valued something wrongly, what’s wrong to you may be right for me. You don’t know my value scale.